Friday, June 24, 2011

The Perils of Technology Investing: RIM & Cisco

I'm always surprised when media pundits and analysts are surprised that one-time dominant technology firms exhibit flagging total returns. Consider two recent examples, RIM, the maker of the Blackberry, and Cisco.

The nearby price chart for the two firms and the S&P500 Index for the past twelve years demonstrates several points.

The first is that buy-and-hold for technology stocks is very risky, even coming in different varieties of risk. For example, RIM rose, then fell precipitously in the early 2000s, only to rise stupendously by 2008, then stall and falter. Such volatility would have tried any shareholder's patience.

Meanwhile, Cisco entered its lost decade after the late-1990s technology stock bubble collapse. Both would have been good bets, in 2000, to hold, if you believed in long-cycle holding for technology issues.

However, of all the companies to experience Schumpeterian dynamics, I suspect technology firms are the most vulnerable.


Because, being at the cutting edge of technology probably attracts more smart, well-funded and motivated competition than being in, say, laundry detergent. The intricacies and dynamics of early-users and trend followers, plus the nature of technologically-based competition can cause market shares to plummet almost overnight.

Prior to the iPhone, who would have foreseen RIM's demise? But what was an interesting sideways expansion by Apple of its iPod vehicle into personal communications has essentially wrecked RIM, probably for good.

Technology companies seem to be especially vulnerable to what my old Chase Manhattan boss and mentor, Gerry Weiss, and his former GE colleagues Don Heaney and Jack Grossman, identified in the 1970s as competition from different arenas.

What they meant by the term and characterization is exemplified by Apple's iPhone. A company from one sector finds that its strengths and capabilities would completely undermine the business models of existing firms in another sector, creating a new competitive arena. The new entrant, Apple, rewrites the rules and redefines the nature of competitive offerings in the existing sector.

In contrast, Cisco seems to have succumbed to conventional competitive forces in its traditional product/markets while squandering resources on new products which didn't develop profitably. This is a more classic example of how technology firms age and die. Their original business segments become saturated or attract competition, while their new initiatives prove to be less successful than their original ones. Growth slows, spending on new products fails to ignite new profit streams, and the company's total returns stagnate as investors become disenchanted.

I read with some humor this morning's Wall Street Journal piece involving Ralph Nader. According to the article, Nader first bought Cisco shares in 1995, and, by 2000, his $1MM position constituted a third of his portfolio.

"At Thursday's closing price, his stake is valued at $278,460....."Just think of what people who have been loyal to them have endured (Nader) said. It's absurd." He said he didnt' sell his Cisco stake because he thought the shares would rebound."

I actually laughed when I read that quote of Nader's. Loyalty? To a technology company? What does Nader think equity invesetment is, a close friendship? Nader's experience demonstrates how not to approach investing in technology firms.

The only thing that's absurd is Nader's blind faith that a firm leading one of the hottest technology areas of the 1990s- network routers' would retain its dominance and relevance in the same manner for another decade.

Technology issues offer prospects of rapid gains, but rarely have successful second acts. My equity portfolio strategy profited nicely from owning Cisco at one time, but it never re-entered the portfolio after 2000.

Buy-and-hold investment styles in specific technology companies is risky and typically unsuccessful due to the dynamic and hyper-competitive nature of the segment.

Thursday, June 23, 2011

Large US Bank Performance In The Wake of Concerns Over Increased Capital Requirements

Tom Brown's announcement in early June that he had bought BofA shares for his sector fund. That post was on June 3rd, so Brown bought no later than that- perhaps in late May, perhaps earlier that week.

On June 9th, I wrote this post discussing the subsequent call by various regulators for large "too big to fail" banks to hold from 3% to perhaps 7% additional capital.

As of yesterday, the major US banks included in the nearby price chart, have all declined since late May. The S&P500 Index is about flat.

We don't know precisely when Tom Brown bought his fund's BofA shares, but all of the banks shown- Citigroup, Chase, BofA and Wells Fargo- have declined absolutely and relative to the S&P for the past three months.

No wonder Brown was cheering on Jamie Dimon's objections to the sensible call for these banks to be capitalized as, well, banks, rather than unsecured loan providers.

Could it be that between the divestitures and closures of now disallowed businesses, and the specter of higher capital requirements, these banks are in for a long term correction down to price levels more consistent with giant, slow-growing, government-insured deposit-taking financial utilities?

Alan Meltzer On Alan Blinder's Keynesian Position

In yesterday's post I discussed Princeton economics professor Alan Blinder's poorly-reasoned editorial warning of a shortfall of government spending.

It turns out that Blinder's piece was just a part of a larger current exchange in several venues between liberal Democratic Keynesians and their adversaries who espouse more modern economic theories.

On Tom Keene's noontime Bloomberg program he described the Krugman/Blinder Keynesian position versus that of Alan Meltzer and other more modern economic thinkers, then had an on-air talk with Meltzer.

Meltzer noted that Krugman and, by inference, Blinder, espoused a rather old, primitive Keynesian brand of economic theory which ignores the last few decades of rational expectations work.

Specifically, Meltzer discussed more recent economic work showing that investors and consumers take note of government actions and develop expectations as a result which then affect their behavior.

These reactions involve several of the points I made in yesterday's post, i.e., expectations by consumers and investors regarding future tax and interest rates affect their behavior in a very dynamic and sensible manner. Some of that effect can result in a sort of palsy, in which both spending and investment await less government intervention and more predictable behaviors.

Meltzer's comments added an interesting dimension to the exchange because, without appearing mean-spirited, he basically characterized Blinder, Krugman and their kindred economists as rather backward and primitive, clinging to a discredited, eighty-year-old theory which has been eclipsed by new theory based upon empirical research.

Between Reynolds' empirical work undercutting traditional Keynesian stimulus programs, and the Nobel-prize winning work of Lucas and Prescott on rational expectations, it's difficult to understand why any thinking person would take Blinder's and Krugman's ideas seriously.

While I didn't read about Lucas' work while in college or graduate school or, for that matter, years after that, I noticed something which the linked site attributes to him, i.e., that modern Keynesians tend to build econometric models which are bereft of explicit theoretical bases or explanations, as well as being susceptible to only fitting periods on which they were calibrated, rather than being generically effective at prediction of consumer or investor behaviors.

Wednesday, June 22, 2011

Alan Blinder's Latest Attempt To Revive Keynesian Economics

I know Princeton economics professor and former Fed member Alan Blinder is a liberal Keynesian economist. But in yesterday's Wall Street Journal editorial, he displayed an ability to play fast and loose with contexts, as well as so narrowly define terms and situations as to make his points irrelevant.

He began by writing,

"Right now, I'm worried about the damage that might be done by one particularly wrong-headed idea: the notion that, in stark contrast to Keynes's teaching, government spending destroys jobs.

No, that's not a typo. House Speaker John Boehner and other Republicans regularly rail against "job-killing government spending." Think about that for a minute. The claim is that employment actually declines when federal spending rises. Using the same illogic, employment should soar if we made massive cuts in public spending—as some are advocating right now.

Acting on such a belief would imperil a still-shaky economy that is not generating nearly enough jobs. So let's ask: How, exactly, could more government spending "kill jobs"? "

Blinder is engaging in incredibly literal interpretation of a statement that isn't meant to convey what he chooses to draw from it.

To begin with, empirically, Alan Reynolds has done research, about which he wrote in a Journal editorial, which has effectively dismissed the contention that government intervention in recessions helps economies. I mention this because later in his editorial, Blinder appeals to empirical evidence, or the lack of it.

Regarding 'job killing government spending,' it's not meant to be a direct and simple logical proposition as implied by Blinder's semantics. Rather, in the current context, with pre-existing uncertainty regarding government extra-legal intervention in business sectors (health care, autos, finance, insurance), aggressive regulatory actions (energy, autos, finance, health care), combined with record government debt and deficits, further deficits or higher taxes to finance more spending is seen as driving businesses to refrain from domestic expansion and/or new hiring. Additionally, the increasing deficits are expected to lead to higher rates on government borrowing demanded by investors, which will raise the deficit, which will eventually require, combined with the other economy-retarding government policies, higher taxes.

These are nuances points, but Blinder's not interested in the reality of nuances as he continues,

"The generic conservative view that government is "too big" in some abstract sense leads to a strong predisposition against spending. OK. But the question remains: How can the government destroy jobs by either hiring people directly or buying things from private companies? For example, how is it that public purchases of computers destroy jobs but private purchases of computers create them?

One possible answer is that the taxes necessary to pay for the government spending destroy more jobs than the spending creates. That's a logical possibility, although it would require extremely inept choices of how to spend the money and how to raise the revenue. But tax-financed spending is not what's at issue today. The current debate is about deficit spending: raising spending without raising taxes."

Blinder is wrong on both points. It's precisely government's ill-advised spending that is at issue. Such as bailing out GM, rather than letting it be reorganized through conventional bankruptcy. Plus, such government spending inevitably invites cronyism, e.g., Jeff Immelt's GE and its curious ties with the current administration and benefits from all manner of environmentally-related government-procured favors.

Further, "tax-financed spending" is indeed part of what's at issue today. In order to avoid further borrowing, the current administration is using the debt limit crisis to try to force higher tax rates and new taxes.

Blinder continues to write,

"For example, the large fiscal stimulus enacted in 2009 was not "paid for." Yet it has been claimed that it created essentially no jobs. Really? With spending under the Recovery Act exceeding $600 billion (and tax cuts exceeding $200 billion), that would be quite a trick. How in the world could all that spending, accompanied by tax cuts, fail to raise employment? In fact, according to Congressional Budget Office estimates, the stimulus's effect on employment in 2010 was at least 1.3 million net new jobs, and perhaps as many as 3.3 million."

Well, as Blinder would know if he read the business press of the past few years, most of that so-called stimulus was used to fund transfer payments to state and local governments. It didn't create jobs, but it may have maintained some. Blinder evades the question of whether simply leaving the governments to resolve their own longer term fiscal situations wouldn't be better for the nation in the first place.

Oh, those pesky details that fall outside of economics.

Then Blinder turns to the fabled "crowding out" effect,

"A second job-destroying mechanism operates through higher interest rates. When the government borrows to finance spending, that pushes interest rates up, which dissuades some businesses from investing. Thus falling private investment destroys jobs just as rising government spending is creating them.

There are times when this "crowding-out" argument is relevant. But not today. The Federal Reserve has been holding interest rates at ultra-low levels for several years, and will continue to do so. If interest rates don't rise, you don't get crowding out."

I don't believe it's quite that simple just now. Rather than crowd out private investment via higher rates, perversely, private lending is stalled because everyone knows current rates don't cover risk. Especially when we just suffered through a residential housing-initiated financial crisis triggered by the Fed's low-rate policies.

Did you really forget that already, Alan?

Plus, the crowding out now occurring is businesses expecting higher taxes at some point to pay for all the deficit spending. That's implicitly crowding out domestic investment as businesses wait for the uncertain other government fiscal shoes to drop in the form of new taxes or higher tax rates.

Blinder then offers this,

"In sum, you may view any particular public-spending program as wasteful, inefficient, leading to "big government" or objectionable on some other grounds. But if it's not financed with higher taxes, and if it doesn't drive up interest rates, it's hard to see how it can destroy jobs."

He simply ignores the transmission effect I noted in my earlier comments, i.e., deficit spending means higher future taxes, in part due to the US government's debt becoming objectionably large to global investors. How Blinder can ignore this is a mystery to me, unless it's because he is an economist, not a financier.

Blinder then appeals to his liberal colleague Paul Krugman's argument,

"Let's try one final argument that is making the rounds today. Large deficits, it is claimed, are creating huge uncertainties (e.g., over what will eventually be done to reduce them) and those uncertainties are depressing business investment. The corollary is a variant of what my Princeton colleague Paul Krugman calls the Confidence Fairy: If you cut spending sharply, confidence will soar, spurring employment and investment.

As a matter of pure logic, that could be true. But is there evidence? Yes, clear evidence—that points in the opposite direction. Business investment in equipment and software has been booming, not sagging. Specifically, while real gross domestic product grew a paltry 2.3% over the last four quarters, business spending on equipment and software skyrocketed 14.7%. No doubt, there is lots of uncertainty. But investment is soaring anyway."

I suppose this is where economists show their ignorance of actual business operations. Business spending by US corporations doesn't mean that spending occurs in the US, or employs more workers in the US. Much of the growth of the S&P500 corporations recently has been overseas, not in the US. Blinder and Krugman fail to distinguish between domestic and foreign investment, spending and hiring by US multi-nationals.

Finally, Blinder closes with,

"Despite all this evidence and logic, some people still claim that fiscal stimulus won't create jobs. Spending cuts, they insist, are the route to higher employment. And ideas have consequences. One possibly frightening consequence is that our limping economy might have one of its two crutches—fiscal policy—kicked out from under it in an orgy of premature expenditure cutting. Given the current jobs emergency, that would be tragic.

Yet it is undeniable that we have a tremendous long-run deficit problem to deal with—and the sooner, the better. So it appears we're caught in a dilemma: We need both more spending (or lower taxes) to create jobs and less spending (or higher taxes) to tame the deficit monster. Can we square the circle?

Actually, yes. Suppose we enacted a modest fiscal stimulus program specifically designed for maximum job creation. My personal favorite is a tax credit for firms that add to their payrolls, but there are other options. And suppose we combined that with a serious plan for reducing future deficits—and enacted the whole package now. Then we could, in a sense, have our cake and eat it, too."

I disagree with Blinder's contention that "we need ..... more spending." Blinder seems unwilling, Keynesian that he is, to simply accept the conclusions of Reynolds' empirical work on the ineffectiveness of government fiscal expansionary policies, and let the US economy endure the natural cycles that private savings, spending and investment will cause.

Many observers, myself included, feel that government spending is the wrong response to the current economic situation. Better to trim government borrowing, by cutting spending, thus improving prospects for Treasury debt offerings and avoiding higher tax rates and new taxes, to leave more money in the private sector. That money will either be spent, or invested, according to private sector appetites, leading, either way, to economic growth.

Why can't we just do that? Allow the private sector to spend and invest its own money as it chooses, rather than force it to either disgorge its money to the government via taxes, or force it to take on liabilities as our government continues to borrow- and spend- on the private sector's account?

Tuesday, June 21, 2011

Holman Jenkins On Bank Bashing

Holman Jenkins, Jr., of the Wall Street Journal wrote a thoughtful, if somewhat murky piece in this past weekend's edition of the paper.

Entitled Why We Aren't Bashing Banks, Mr. Jenkins seemed to attempt to address a number of specific topics related to the Greek and European debt/bank crisis, including responding to left-wing economist Paul Krugman.

What interested me about Jenkins' article, however, were two of his contentions.

The first is that

"politicians find no upside in bashing bankers right now for good reason, since the whole game- 100%- is maneuvering the European Central Bank and its chief Jean-Claude Trichet into a more pliant mood so they will prop up Europe's banking system to permit sovereign debt restructuring to go ahead."

In effect, Jenkins, along with others, alleges that the truth is that bankers bought now-nearly-worthless Greek sovereign debt which, if carried at its correct value, would result in insolvent banks, a severely damaged European banking system, and, for good measure, no more private banking institutions to roll over and hold more of the rotten paper while the European Union figures out what to do about the mounting financial problems of larger EU countries, such as Ireland and Spain.

Thus, despite criticisms of cronyism, the regulators and central bankers are seen to be bailing out Greece, in order to bail out Europe's banks. And right now, that more or less equates to Germany bailing out the EU's banking sector.

My own fascination with this situation is how twisted and selective our international central banking and regulating authorities have become, such that they implicitly suspend the need for banks to recognize losses in value of assets they hold, so soon after the recent financial crises which involved precisely this sort of phenomenon.

Ask yourself why anyone in his right mind would own equities of large banks when such flagrant misstatement of asset values is allowed. If it weren't sanctioned by regulators, it would be called what it is- fraud.

Jenkins' second topic of interest was this passage,

"Here's guessing that a world without too-big-to-fail banks would not be bereft of financial innovation or diversified services aimed at every kind of customer."

He's probably right. My original research on consistent total return performance took place when I headed the research function at then-independent Oliver, Wyman & Co, revealed that the worst-performing financial institutions were the broadly-diversified banks. They hit every financial pothole which occurred- credit cards, mortgage lending, third-world debt, etc. The most consistently-superior performing firms were the more focused asset managers, credit card lenders and mortgage banking firms.

When income from diversified business mixes isn't used to prop up ailing units and mask weaknesses, firms tend to either succeed or fail rather dramatically.

Whether that would happen again, or not, I can't say. It may well be that we've had more financial innovation than any global economy can stand for a while. But, as Jenkins implies, with smaller, more nimble and focused financial institutions, profitable innovations would succeed, others would not, and investors in and lenders to such enterprises, rather than taxpayers, would enjoy the appropriate consequences.

Monday, June 20, 2011

Dominos, Jack Welch & CNBC: Recipe for Disaster?

For the past few weeks, CNBC has been playing trailers of its new reality business consulting program starring ex-GE CEO Jack Welch and his latest wife, Suzy. Today's trailer and, evidently, the current 'client,' if one may use the term, is Domino's Pizza.

My first reaction was to remember an old Greek aphorism which says, to paraphrase,

'You cannot give what you do not have.'

What, precisely, does anyone think Jack Welch has, or ever had, in the way of demonstrating consistently superior management leading to similar total return performance? Let's dispense with his current wife, Suzy, who once was, I believe, editor of the Harvard Business Review. I haven't heard HBR cited as a valued business literature resource for over a decade. And Suzy was only an editor when she met and subsequently had the affair with Welch which contributed to ending his then-current marriage. Which is to say Suzy Welch's involvement seems to be exclusively the result of her current marriage.

Welch was CEO of GE from 1981-2001. Yahoo's stock price chart function isn't allowing comparisons now (or perhaps anymore), but this prior post contains the chart I want to display and, conveniently, is also one of the topics on which I'll remark shortly.

The chart from that post, reproduced nearby, doesn't include dividends, which would affect both series. But what it still illustrates is how closely GE tracked the S&P500 for most of the first decade of Welch's tenure as CEO.

I had the occasion to meet with him in the mid-1990s when I was with Andersen Consulting, now known as Accenture. Back then I was using the DowJones price series, rather than the more appropriate S&P. However, even with the S&P the point I made to Welch which got him scribbling on his copy of my presentation, exclaiming,

"Nobody's ever shown me this before,"

is still evident. If you look carefully at the blue curve around 1982-3, you'll see a near-vertical rise which lifted the then-ailing conglomerate's performance up above the S&P's, and was retained for nearly eight more years.

I contended to Welch that this was the initial benefit to GE's total return which his triage among the inflationary climate and GE's moribund businesses left to him by Reg Jones produced. At the time, amidst unreliable GAAP numbers due to rocketing inflation, Welch resorted to managing by market share and its growth. This was unquestionably an astute and, ultimately, successful approach. Though it earned him the moniker Neutron Jack for cutting GE's workforce, it produced excellent performance for years. But after that, for the remainder of the decade, GE largely tracked the equity indices without significant, lasting outperformance. This was what had shocked Welch as he stared at the simple but powerful graphic I had presented to him.

By the time I met with Welch, GE had become a lopsided giant, with a fast-growing, risky financial services arm outstripping the slow-growing industrial units.

Ultimately, GE's total returns of the late 1990s were produced from two sources- analysts' belief in Jack Welch and his consistent production of dividends, and a ballooning finance business which benefited from the overall halo effect on such businesses. On both an absolute basis, and relative to the S&P, GE has never again reached the heights it attained in Welch's last year.

Upon taking over as CEO at GE, Jeff Immelt was immediately assailed for the same accounting practices in units such as power generation for which pundits had given Welch a pass. GE Capital, which had lost Gary Wendt, the architect of its expansion, a few years earlier, no longer powered the conglomerate's growth.

Thus, it's unclear exactly what Welch left of enduring value at GE, given that, within months of his departure, the company's total returns fell off a cliff.

Since Welch constantly preached about good management, one would think that choosing an able replacement and handing off GE in decent shape would be key to Welch's being judged a success.

But that's not what happened. Immelt proved incapable of handling GE, which has, under his misleadership, managed to squander all of the performance margin it had accreted since 1962. Not to mention that little matter of requiring a federal government bailout under TARP to avoid insolvency in 2008-09.

Elsewhere, Welch's spawn did little better. Bob Nardelli had to be chased out of his CEO position at Home Depot, while Jim McNerney's 3M and Boeing both have struggled.

Then there is the question of Welch's major acquisitions, which I would suggest were RCA and Kidder Peabody. The latter was the subject of a huge scandal literally the week during which I met with Welch in the mid-1990s. The linked post referenced earlier in this piece discussed the RCA acquisition, ending with these observations,

"1986 was a long time ago. Many analysts from that era are retired, and the tenor of those times is long forgotten. But revisiting the event of GE's acquisition of NBC is important, if only in fulfillment of the time-honored saying reminding us that those who don't learn from history are doomed to repeat it.

From a sufficiently long perspective of time, it is clear that NBC was never the magical acquisition Welch imagined. If it was the reason for a spurt of market outperformance in Welch's latter years, then it should have been spun off or sold at its peak, rather than be ridden down in value to its current situation.

Either the acquisition, or its management and disposal, were flawed. And there's no telling how much management distraction NBC caused during its years in the GE corporate portfolio.

I think that, by all accounts, GE's acquisition of NBC was a mistake at the outset, was a drain on GE's management, and was ill-managed in terms of timing the firm's exit from the unit as its value deteriorated in the rapidly-changing media environment of the internet and digital era."

In line with my continuing theme regarding GE, Welch made the firm an even more unnecessarily-diversified firm in an era in which the raison d'etre for such diversified conglomerates had long-since disappeared. If anything, Welch should have been spinning the major units of GE into separate businesses and dissolving the firm that he had run for two decades.
At the dawn of Welch's tenure, diversified conglomerates were already dinosaurs, due to falling brokerage rates. With the appearance of large discount retail brokers like Charles Schwab, there was no purpose, other than employing a bunch of headquarters staff, Welch and his CFO, for GE's existence in the form Welch had inherited.
Welch's decade of superior performance at GE was apparently more the result of luck and the bounce-back from his adroit initial handling of the mess Jones bequeathed to him. My old boss and mentor at Chase, Gerry Weiss, who had been the senior corporate planning officer at GE before being recruited by David Rockefeller, always contended that Welch should have been handsomely compensated for handling the mess he inherited, and dispatched by the end of the 1980s. His long-term growth efforts resulted in disaster for the firm.
Moreover, Welch never ran a retail business. He was a chemistry PhD who rose to run the plastics business and, from there, GE. GE, for that matter, has never been a retail presence, either.
So, if you're the CEO of Dominos, and you know all this, what is it that you think Jack Welch can do for your company? Do you want what happened to GE after Welch's magic touch to happen to your pizza delivery firm?
So just what would Welch uniquely bring to the pizza chain, if his accomplishments at GE melted away so quickly? He doesn't have a track record as a successful consultant to numerous companies in various industries.
What's the point of Welch's CNBC program if he can't provide what he never had in the first place?